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How to Short Munis

by John Rubino on November 22, 2010 · 9 comments

From Saturday’s Wall Street Journal, more on the federal government’s ongoing stealth bailout of US states:

States Raise Payroll Taxes to Repay Loans

Thirty one states, their unemployment-insurance funds empty, have borrowed nearly $41 billion from the federal government. California alone has borrowed nearly $8.8 billion as of mid-November, according to the Labor Department.As states try to replenish the funds and begin to repay the loans, employers are facing increases in both state and federal payroll taxes, a potential barrier to new hiring.

“Employers were hit with these adjustments quite a bit last year,” said Richard Hobbie, executive director for the National Association of State Workforce Agencies. A National Employment Law Project analysis found 41 states increased unemployment-insurance payroll taxes this year by an average of nearly 33.9%. The largest was a 168.5% boost from 2009 in Hawaii.

States in the Red

Most states have addressed or still face gaps in their budgets, while tax revenue declined.

Payroll taxes levied by states fund unemployment benefits for up to 26 weeks—and longer in some states. The federal government requires states to pay benefits even if their unemployment funds run out of cash. As in past periods of high joblessness, the federal government has paid for extended unemployment benefits, this time for as long as 99 weeks.

The unemployment-compensation system, initiated during the Great Depression, was designed so most states build reserves when jobs are plentiful and few workers are receiving benefits, and then draw down the reserves in bad times. But few states were prepared for a recession as deep and lasting as the recent one, with unemployment remaining at a historically high 9.6% a year after the economy resumed growing.

During the 2008-09 fiscal year, states collected $31 billion of unemployment-insurance taxes and spent $79.4 billion on jobless benefits. Taxes are typically levied on a per-worker basis.

Arizona, which owed the federal government $172.8 million as of mid-November, increased its tax on employers by more than 50% at the beginning of this year to an average of $145.60 a year per employee. “The dilemma we face is, how do you do that without hurting the economic recovery we all hope is coming?” said Steve Meissner, communications director for the Arizona Department of Economic Security.

Indiana Gov. Mitch Daniels proposed cutting unemployment benefits earlier this month despite his state’s 10.1% unemployment rate. Indiana has borrowed nearly $1.9 billion from the federal government to shore up its unemployment-compensation fund; next year, the state is to begin taxing businesses more to replenish the coffers.

Federal loans to states have so far been interest-free under a provision in the Obama administration’s 2009 fiscal-stimulus law. But that waiver expires in January.

Texas, which has borrowed nearly $1.6 billion from the federal government and raised employer taxes, is offering $1.1 billion in tax-exempt bonds to repay loans before Washington begins imposing interest charges because, said Ann Hatchitt, a spokeswoman for the Texas Workforce Commission. The state, which employed the same strategy in the early 2000s recession, figures it will pay investors less than it has to pay the federal government.

Time To Short Muni Bonds?
This looks a lot like the bailout that Ireland just got from the EU and IMF. But Ireland’s troubles are front page news while California, Arizona and New York get their bailouts under the radar via already-existing programs like unemployment benefit extensions and Build America Bond subsidies. So the true magnitude of the state financial crisis is buried in hard-to-decipher Treasury Department line items. When and if someone adds it all up, the number will be shocking.

Perhaps in anticipation, munis got whacked last week, and now yield more than not just Treasury bonds, but some taxable corporate bonds. So munis might finally be interesting short candidates. Here are some ways to bet against them:

Muni ETFs and closed-end funds
Both ETFs and closed funds theoretically can be shorted like stocks. These days the “theoretically” is key, because finding shares to borrow and sell is no longer a given. But if the shares are available, shorting these funds is a fast, simple way to get broad short exposure. This strategy has a cost, however, since closed-end muni funds and ETFs pay dividends that a short seller must cover.

Closed End Muni Funds
Eaton Vance Municipal Bond Fund (EIM)
Van Kampen Trust for Investment Grade Municipals (VGM)
Eaton Vance Insured Municipal Bond (EIM)
Blackrock Municipal 2020 Term Trust (BKK)
MFS High Income Municipal Trust (CXE)
PIMCO California Municipal Income Fund III (PZC)

Long-Term Muni ETFs
iShares S&P National Municipal Bond Fund (MUB)
Market Vectors-Lehman Brothers AMT-Free Long Continuous Municipal Index (MLN)
PowerShares Insured National Municipal Bond Portfolio (PZA)
PowerShares Build America Bond Portfolio (BAB)
SPDR Lehman Municipal Bond ETF (TFI)

End-Date National Muni ETFs
iShares 2015 S&P AMT-Free Municipal Series (MUAD)
iShares 2016 S&P AMT-Free Municipal Series (MUAE)
iShares 2017 S&P AMT-Free Municipal Series (MUAF)

State-Specific Muni ETFs
iShares S&P California Municipal Bond Fund (CMF)
iShares S&P New York Municipal Bond Fund (NYF)

Muni credit default swaps
The hedge funds that made a killing on the housing bust did so mostly by buying credit default swaps (insurance that pays off in the event a bond defaults) on mortgage-backed bonds. Tthe muni version is available via the MCDX, an index containing 50 equally-weighted credit default swaps for major muni issuers.

Bond insurers
The insurance companies that guarantee the interest on less-than-stellar munis are on the hook if defaults exceed historical levels. AMBAC just filed for bankruptcy, leaving MBIA, Assured Guaranty, and Berkshire Hathaway as potential shorts.

Owners and underwriters
According to the Federal Reserve, commercial lenders have been steadily increasing their muni holdings in recent years, and now own bonds worth about $215 billion. The muni portfolios of Citigroup, State Street, and U.S. Bancorp, for instance, rose to 25-year highs in the first quarter. Several major banks, including Bank of America, Citigroup, and Barclays are also underwriters of munis.

Insurance companies, meanwhile, reportedly own about $450 billion of munis, with Travelers and American International Group owning $41 billion and $45 billion, respectively.

  • Sam Williamson

    Thanks John, when will we know the time to do this
    Sam W in CA

  • Bruce C.

    Personally, I wouldn’t try to short municipal bonds because the traditional/normal market dynamics no longer apply.

    JR seems to imply that because of the states’ needs to borrow money their municipal bonds will have to pay more interest to attract buyers/lenders, so bond prices should go down – hence the short.

    However, I believe that is too myopic. The Fed has stated that their QE II program will be “driven by conditions”, which most people assume means the duration, and perhaps even the amount, of Treasury purchases will be based upon monthly inflation and employment numbers. I believe it also means that the Fed will buy whatever else it deems suitable to stimulate job growth and avoid deflation. If the Fed sees muni bond rates creeping up then I would expect it to begin buying them off the open market (which is how the QE II program is set up) to support their prices and cap their coupon rates.

    Remember, muni bonds, along with Treasuries, are the primary assets held by most wealthy individuals. And, now that the big banks are holding them as well, the Fed will be doubly sure to protect their value. I just don’t think the Fed will allow them to drop significantly.

  • Bob

    How is the Fed doing with keeping housing prices up? Gold is up 3%-35% since the 2008 crisis – isn’t that telling us something or is it just noise. I think you are right in the short term – but, ultimately doesn’t the Feds intervention create a Funding crisis – where interest rate climbs and the currency drops in value?

    Isn’t the Fed”pushing on a string”?

    • Bruce C.


      Those are good and important questions. They are also very different questions.

      The important distinction is the size and nature of the market participants. Only in relatively “closed” investment environments can the Fed’s efforts be influential. For example, Treasury and municipal bonds are issued by politicians and bureaucrats (the supply) and the purchasers (the demand) are all “heavy hitters” consisting of high to very-high wealth individuals, domestic institutions (e.g., pension funds and banks), foreign entities of the same, and the Fed itself. They usually have the same agendas, and the Fed can generally move or influence that market, just in case. All of the above want to maintain muni and Treasury bond values.

      Now, in the case of housing, the market is completely different. The supply consists of “unmotivated sellers”, be they banks or individuals, and the demand consists of RE investors and individuals looking for bargains. The only way the Fed can enable this cluster f _ _ _ is to lower interest rates. However, even that doesn’t work, because both sides use that to oppose the other (the same applies to subsidies). Sellers say, “Now you can pay my price because your purchasing cost has dropped”. But buyers reply, “That just means you don’t have to lower your price as much as you would have.”

      Now, the dollar rise in gold price is very different than both the housing and the bond markets. In this case, the market consists of contrarians and other “unofficial” outliers (the demand) and venal, dollar-centric “optimists” (the supply). And, to further thicken the plot, no one really knows who has what. So far, gold buyers have been primarily jewelers, individual investors/traders, investment funds (ETFs like GLD), and central banks. The sellers have been jewelry owners, individual investors/traders, and the IMF. Furthermore, the macro-economic environment has been a falling dollar, unpayable debt levels almost everywhere – and the US in particular, and unprecedented Fed policies which have created currency debasements worldwide. It all begs the question, “What good is X-amount of currency if it isn’t worth anything?” Combining all of that with the fact that most central bankers are devoted to the concept that the highly sophisticated complex of fiat money is “advanced and sustainable”, and you get road kill after the dust settles.

      Finally – yes – long-term interest rates rise and the dollar drops, but the point of this article is the shorting of munis NOW, which I consider to be too late.

  • Bob II

    Of COURSE the Fed is NOT keeping housing prices up. How about minus 10 percent interest rates. THAT oughta hold ’em, not. Very sad, indeed. I don’t know who is less knowledgable about economics, Bush or Obama. “I had to dispense with free trade to save free trade” (bush) or “spread the wealth around” (obamy). Our goose has already been cooked. They’re just waiting till we’re well done before the bankster elites eat. They “rescued” Ireland, and about to “rescue” the rest of the EU. Slavery, here we come. Adolph Hitler would have been beside himself with joy to have captured the entire European continent without firing a single bullet, just like Germany has now. Be sure of one thing, Russia is aware. WW III, comin’ up!

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  • David Ziffer

    I think it would be pretty silly to actually really go out and “short” munis in the manner described in this article. Yes munis are probably headed for enormous defaults but like the big banks of 2007-8 they are too big to fail. The Fed will step in and print however much money is necessary to prop everything up. So although in reality the states and cities will have collapsed financially, their balance sheets won’t reflect it, and even though you will have been right, you could lose your shirt.

    It’s just like the tax effects of inflation (feel an analogy coming?). You buy investments because you want to stay out of cash, which is being debased. The price of your investments rises with the inflation rate. You were technically correct and all you did with your investments was preserve your purchasing power; i.e. there was no real gain. But the government says you made money, and taxes you on the imaginary gain.

    The inverse will happen if you short munis. You’ll be technically right to do so and they’ll collapse, but the Fed will prop them up with unlimited funding. So even though the bonds should have lost money, the numbers will say they didn’t. At best you’ll break even. At worst it could be a dark day for your portfolio.

  • Steve Linton

    Looks like the author was right. Munis got pounded last week and will continue to

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